Corporate Finance & Securities

Employee Equity Compensation Plan: How to Slice the Pie?

Employee EquityStartup founders will often wonder how much employee equity they should give.  While there is no bright line rule for how to allocate equity in your equity compensation plan, there are a number of factors to consider to craft the appropriate equity compensation plan for your startup.

Types of equity to grant

Equity can be broken up into common stock and preferred stock. It’s unusual for a startup to issue preferred stock to anyone but an investor in the company, so we’ll focus on common stock. Common stock is a security that represents ownership in a corporation. Holders of common stock exercise control by electing a board of directors and voting on corporate policy. Common stockholders are on the bottom of the priority ladder for ownership structure. In the event of liquidation, common stockholders have rights to a company’s assets only after bondholders, preferred shareholders, and other debtholders have been paid in full.

Early stage companies will usually issue common stock to an employee of the company via the use of restricted stock or through stock options.

Restricted stock is stock that is subject to forfeiture to the company, either for compensation or for no additional compensation. Restricted stock is generally subject to forfeiture until the stock vests. For example, an early stage company may issue stock to its founders, but the founders are only entitled to the stock if they continue to work for the company for a specified period of time. The shares will vest according to the vesting schedule. Once the stock is vested, it is no longer subject to forfeiture.

Stock options, on the other hand, give the employee the option to purchase shares in the company at a fixed price in the future.

To grant compensation in the form of restricted stock or stock options can be costly, as it results in dilution to the current stock holders (see a detailed post on dilution here).

Another form of compensation that a company can grant, although less commonly used, is convertible debt. With convertible debt, the price of the stock is not calculated at the time of investment or grant. Recipients of the convertible debt have rights to interest, and the conversion price is not determined until the company receives a “follow on,” or subsequent round of financing. If the company does not receive a follow on round of financing before the debt matures, the investors can call in the debt.

Convertible debt holders usually get a discount, meaning that they’ll pay a certain percentage less than the new investor. For example, if the follow-on round values the company at $5mm and there’s a 20% discount, the debt holders’ interest will convert at a valuation of $4mm.

The convertible debt may also have a price cap. A price cap works like this: if there’s a $20mm price cap and the follow on investors value the company at $50mm, the convertible debt holders’ interest will convert at a $20mm valuation–meaning they will get a greater interest in the company than they would have if their investment was converted at the $50mm price.

So how much employee equity should early stage companies grant?

I think prominent venture capitalist, Fred Wilson, states it best “For your first key hires, three, five, maybe as much as ten, you will probably not be able to use any kind of formula. Getting someone to join your dream before it is much of anything is an art not a science. And the amount of equity you need to grant to accomplish these hires is also an art and most certainly not a science.” For a detailed discussion on this topic from Fred, see here.

While there is no bright line rule on how much equity to give to early stage key employees, another article by a group of prominent venture capitals from the Foundry Group shows a range of between .5% – 8% equity for key employees such as President, COO, and CTO. These numbers will vary greatly depending on a number of factors about the individual you are hiring such as:

  • Domain expertise
  • Connections
  • Experience with related ventures
  • Ability to make significant contributions
  • Replaceable – are there lots of other people out there who can do the same thing?
  • Part-time vs. Full-time – doing something on the side is less valuable

If you’d like to learn more about structuring your equity compensation plan and granting employee equity, please feel free to contact us today.

Photo: Flickr I Jamieanne

        


Collin Roberts

When he's not in the office, Collin enjoys IPAs and burgers at Latona Pub.


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